Ross Stores Inc (ROST) — Q1 2018 Earnings Call Transcript

Good afternoon. Joining me on our call today are Michael O'Sullivan, President and Chief Operating Officer; Gary Cribb, Group Executive Vice President, Stores and Loss Prevention; John Call, Executive Vice President, Finance and Legal; Michael Hartshorn, Executive Vice President and Chief Financial Officer; and Connie Kao, Vice President of Investor Relations. We'll begin our call today with a review of our first quarter performance, followed by our outlook for the second quarter and fiscal year. Afterwards, we'll be happy to respond to any questions you may have. As noted in today's press release, despite unfavorable weather throughout the period, we achieved above-planned growth in both sales and earnings in the first quarter. Earnings per share for the 13 weeks ended May 5, 2018, were $1.11, up from $0.82 for the 13 weeks ended April 29, 2017. Net earnings were $418 million, up from $321 million in the prior year. These earnings per share results include a $0.17 per share benefit from recently enacted tax legislation and a $0.02 per share benefit from the favorable timing of packaway-related costs that we expect to reverse in subsequent quarters. Total sales for the quarter increased 9% to $3.6 billion. Comparable store sales for the 13 weeks ended May 5, 2018, rose 3% over the 13-week period ended May 6, 2017. This growth compares to a same-store sales gain of 3% for the 13 weeks ended April 29, 2017. We estimate that unfavorable weather throughout the quarter reduced our comparable store sales by over 1%. For the first quarter, the strongest merchandise category at Ross was men's, while geographic trends were very broad-based when normalized for weather. Operating margin for the period of 15.1% was down slightly from the prior year as an improvement in merchandise gross margins and favorable timing of packaway-related expenses were offset by higher freight costs and wage-related investments. As we ended the first quarter, total consolidated inventories were up 19% over the prior year, mainly due to higher packaway levels as our buyers were able to take advantage of numerous opportunities in the marketplace. Average in-store inventories were up 2% as planned due to an earlier Mother's Day this year. While packaway, as a percentage of total inventories, was 49% compared to 46% last year. We are also pleased to report that dd's DISCOUNTS delivered another quarter of solid growth in sales and operating profits. Our store expansion program is on schedule with the addition of 23 new Ross and 6 dd's DISCOUNTS locations in the first quarter. We remain on track to open a total of approximately 100 locations in 2018, comprised of 75 Ross and 25 dd's DISCOUNTS. As usual, these numbers do not reflect our plans to close or relocate about 10 older stores. Now Michael Hartshorn will provide further color on our first quarter results and details on our second quarter guidance.

Thank you, Barbara. Let's start with our first quarter results. Our 3% comparable store sales gain was driven by higher traffic and an increase in the size of the average basket. First quarter operating margin of 15.1% was down 5 basis points from last year. Cost of goods sold improved 20 basis points in the quarter, driven by 30 basis points of higher merchandise margin and distribution cost that declined by 15 basis points, mainly due to the previously mentioned favorable timing of packaway-related expenses. Occupancy also levered by 15 basis points. These gains were partially offset by a 20 basis point increase in freight cost and 20 basis points in higher buying expenses. Selling, general and administrative expenses for the period increased 25 basis points, mainly due to higher wage-related costs. During the first quarter, we repurchased 3.3 million shares of common stock for a total purchase price of $255 million. We remain on track to buy back a total of $1.075 billion in stock for the year. Let's turn now to our second quarter guidance. For the 13 weeks ending August 4, 2018, we are forecasting same-store sales to increase 1% to 2% over the 13 weeks ended August 5, 2017. Earnings per share for the second quarter are projected to be in the range of $0.95 to $0.99, which includes the benefit from lower taxes. The operating statement assumptions for our second quarter guidance include the following: total sales are projected to grow 5% to 6%; we expect to open 30 new stores during the period, including 22 Ross and 8 dd's DISCOUNTS locations. If same-store sales are in line with our guidance, then we project operating margin to be in the range of 13.3% to 13.5%. The forecasted decline from last year's 14.9% reflects the unfavorable timing of packaway-related costs as well as our previously announced wage and benefit investments. We expect net interest income of about $900,000. Our tax rate is expected to be approximately 24% to 25% and weighted average diluted shares outstanding are projected to be about $375 million. Based on our first quarter results and second quarter guidance, we now project earnings per share for the 52 weeks ending February 2, 2019, to be in the range of $3.92 to $4.05 compared to $3.55 for the 53 weeks ended February 3, 2018. As a reminder, our fiscal 2018 guidance includes the benefit from lower taxes. In addition, last year's 53rd week added approximately $0.10 to earnings per share for 2017. Now I'll turn the call back to Barbara for closing comments.

Thank you, Michael. To sum up, despite unfavorable weather throughout the period, both first quarter sales and earnings per share outperformed our plan. Looking ahead, we expect the retail landscape, both brick-and-mortar and online to remain very competitive throughout 2018. In addition, we face robust multiyear sales comparison as the year progresses. That said, we remain confident in the strength of the off-price sector and our ongoing ability to perform well in this space. Our focus will remain on offering customers the outstanding values they have come to expect, which has allowed us to achieve profitable growth in sales, earnings, and market share over time. At this point, we'd like to open up the call and respond to any questions you might have.

On gross margin, can you speak to drivers of the 30 basis points in merchandise margin in the first quarter? Any change in freights? And then just larger picture, if we look through tax reform this year, I guess, has anything changed with your double-digit bottom line algorithm, if you are able to drive the 3% to 4% comps?

Sure. So Matt, it's Michael Hartshorn. Let me answer those in pieces. On merchandise margin, as we mentioned in the comments, those were up 30 basis points in Q1. That was driven by better buying. In addition, we benefited from a very clean inventory position entering the quarter. In terms of freight cost, freight has been a headwind for over 1 year. Our outlook has not changed. A number of factors are contributing to the increase. Like others, we have seen significant increases in market rates due to very tight capacity. This capacity seems to be driven by driver shortages, impacts of increased regulation, and perhaps the stronger economy. In addition, diesel fuel costs were up about 20% from last year in the quarter. So we expect freight to be a headwind for the remainder of the year, and that is reflected in our guidance. On your last question, certainly, this year reflects the benefit of tax reform. Our current guidance reflects the 10% to 14% EPS growth that includes about a $0.69 benefit from tax reform. Going beyond this year, there is nothing that's changed in our long-term model.

I guess, curious as we sat here on the Northeast with all the, I guess, the nor'easters to hear you guys talk about unfavorable weather. Can you maybe give us a little more clarity on sort of what markets? Was it just year-over-year in some of your key markets? Just give us a little more color on the weather issues. And then curious on the packaway inventory growth. If you can give us a better sense of maybe what categories or just a good, better, best situation. Just give us a better feel for the packaway inventory growth?

Sure, Brian. Regarding the weather, we estimate that the overall impact on the chain was more than 1%. Every major region experienced negative weather comparisons during the quarter, with the exception of the Pacific Northwest. The areas most affected were the Mid-Atlantic and the Midwest.

And then as it pertains to packaway, what I would say to you is that there is an abundance of merchandise in the marketplace. So we were able to take advantage of those opportunities. And they're pretty broad-based in terms of different types of products. So it isn't just one classification. And I think the merchants have been out there in the market looking to see what's available and felt that the timing was right to buy those goods as that's a big part of their job.

And will there be any implications for the back half regarding packaway or distribution expenses?

In terms of distribution expenses, we had a $0.02 benefit in the first quarter due to how we capitalized packaway costs, and we expect that to reverse, resulting in a negative impact for the remainder of the year.

Can you talk a little bit about the composition of the comp? How much of that was traffic versus basket? And what drove the basket increase?

Sure, Lorraine. As we mentioned in our prepared remarks, the 3% comp was driven by higher traffic and an increase in the size of the average basket. The higher basket was primarily driven by higher units per transaction with AUR being down slightly. A decrease in the AUR was driven by a mix of business.

I wanted to just ask about the SG&A deleverage, 25 basis points. Obviously, I think your guidance this year includes some ongoing deleverage. Is there any guidance you have sort of on a quarter-by-quarter basis, how we should think about that? And then I just wanted to follow up on the weather question. Could we assume that you're seeing some pick up here in May assuming that weather has normalized so far here in Q2?

Sure, Kimberly. On SG&A, the 25 basis point increase reflects a couple of different things. It's the lapping of market-based increases, the wage increases that we made last year as well as the impact of statutory increases that included California increasing to $11 in January. It also includes a piece of wage investments that we're making this year. Our guidance for the remainder of the year would include further deleverage as the year progresses as a result of the associated investments we announced at the beginning of the year, which includes going to $11 throughout the company, payment of one-time bonuses and also improvements to our paid leave programs. And then in terms of weather beyond the quarter, our practice is not to comment about post-quarter trends.

I'm not sure who wants to take this question, but you guys have talked a little bit over the past couple of quarters around the beauty category becoming more of an opportunity for you to buy into. Any updates there on that category, specifically to Q1 and then just updated thoughts as you move forward?

Sure. The beauty category has been a growing category for everyone as the market has shifted around a lot. We feel good about the beauty category. And ourselves, as well as many other people in the industry, feel that it's an opportunity as the market itself is shifting from department stores to other sectors.

Just on the second quarter guidance. I believe, you outlined EBIT rates in the 13.3% to 13.5% range or so, which is down 140, 150 basis points or so at the midpoint year-over-year. Can you just kind of rank or quantify for us to what extent that contraction is wages versus freight versus the packaway expenses in 2Q and any other puts and takes we should be mindful of?

Sure. We won't provide specific numbers, but I'll reiterate that there are three main drivers. The most significant is the investments in wages and benefits, with some occurring in the second quarter. This will cause the deleverage to increase as we move through the year, which is the primary impact for the second quarter. Additionally, there will be negative effects from the timing of packaway-related costs, and freight will continue to be a challenge for us.

Going back to the traffic-first ticket question. Curious if you saw any difference in the Ross business versus dd's on those metrics? And then, separately, also curious if you track how your performance is at centers where you are colocated with another off-pricer if you can maybe share how those stores of yours are performing in the colocated locations with a T.J. concept or Burlington versus those that are in a separate center?

Sure. Paul, I would say the dd's and Ross were proportional in terms of mix of transaction, average unit retail, traffic, and so on. We colocate in about one-third of our chain with either T.J. Maxx, Marshalls, or Burlington, and those stores performed similarly to the rest of the chain.

Any comment on home versus apparel during the quarter?

Overall, non-apparel was slightly above apparel given the weather.

Do you expect the trend in buying expenses on the gross margin line to continue? What factors were influencing that? Additionally, how do you view the potential in non-apparel sectors like home as you consider maximizing store space and exploring new opportunities in categories where customers still value affordability?

Oliver, on buying, expenses can fluctuate quarter-to-quarter. In the first quarter, there were some, I would say, negative timing impacts, but it also reflects mainly that we're going to continue to make ongoing investments in our buying organization.

And as it pertains to opportunities in non-apparel areas such as Home. Actually, Oliver, we think that our opportunities are very broad-based in addition to Home in the entire box. So in terms of maximizing space in the stores, we really decide what businesses we want to drive and then we figure out how it fits within the box.

Got it. So which businesses do you want to drive?

I won't specify which businesses we aim to focus on during this call; I’ll just say that our approach is broad-based and not limited to a single area.

I had a quick question about the sizes business. Historically, this has always been a business you guys have done well with and you've had in your stores forever. And there's quite a buzz around the business right now. So I'm curious just how it's done for you? Are you finding availability starting to be more plentiful or easier to find? And what's your thinking strategically about the business?

The women's sizing market, including special prices, boutiques, and plus sizes, is definitely expanding in the United States. In terms of apparel, there's significant potential here. Currently, there is a lot of availability across most product categories, making supply quite abundant and diverse. Therefore, there is merchandise available. We focus on growth based on customer feedback, targeting the areas that align with their needs.

Fantastic. That's great. And is there any reason to believe that merchandise margins will be pressured? I know you have headwinds as far as wages and freight cost and things like that, but there is a lot of availability in merchandise. It seems like generally the environment, while competitive, isn't in fire sale mode. So is there any reason to believe merchandise margins shouldn't be okay for the rest of the year?

Marni, our guidance assumes that merchandise margins are relatively flat for the remainder of the year.

Just one more question on the weather. Can you break down sort of the methodology that you used to determine that it was about a 1% hit? How do you get there or greater than a 1% hit?

Sure. So we use weather services to do that. And also, obviously, storms are easier to calculate; that's our methodology.

Any more detail?

The only thing I'd add, Laura, that includes both temperature and precipitation.

I have two questions. First, regarding the current marketplace, are the recent store closures by competitors creating more opportunities for you to source products from different vendors? Second, as you continue to expand your store network, how are you managing to attract talent, including both managers and store associates? Are you experiencing any challenges in that area?

So Bob, it's Michael O'Sullivan. First of all, regarding the store closures, it's challenging to determine their impact on availability since it is influenced by various factors. However, the challenges faced by the wider retail sector are likely contributing to improved availability. Specifically about store closures, it's difficult to assess that aspect. As for labor availability, we are very pleased with our success in attracting and retaining employees at all levels within the company.

This is Dan Stroller on for Simeon. We just wanted to know if there's been any notable change either recently or over the past several years in what brands your shoppers are gravitating towards. Basically, trying to figure out if your top-selling brands have really turned over much and gone into favor for new or up-and-coming brands?

For competitive reasons, we really wouldn't talk about brands on the call.

Okay. And then on the consumer base, anything you're seeing in terms of frequency of visit of existing shoppers or I guess, customer acquisition and the initiatives there? That would be very helpful.

Sure. We slice and dice our customer data all the time where we're often out there doing research. And I would say there is nothing to call out in terms of any changes to consumer behavior or demographics or anything of that nature at this point.

Could you speak a little bit more to the change in AUR and the mix base delta there? I think a lot of the competitive set is speaking to positive AURs at this point across both off-price and department stores, frankly. So I'm wondering if there's some kind of category divergence that you guys are pursuing that's causing some puts and takes on your AUR? And if you think that continues to remain a headwind through this year? If you see some reason why the categories that you guys have in inventory with the change in the inventory line there could take some pressure off on that line?

Yes, AUR can vary from quarter to quarter, so it's not something I'm considering strategically. Looking ahead for the rest of the year, it will depend on how each category performs. It's difficult to make predictions at this stage. However, over the last couple of years, the categories have generally performed well. AUR has decreased slightly, but not by much.

I was a bit surprised that the average unit retail was still a challenge in the first quarter despite the weather. I thought you might have targeted some categories for spring that would have led to a higher average unit retail in the comparison. Was this unexpected for you at all?

Not really. Our strategy over a long period has been to price our products as sharply as possible to boost sales, and we applied that approach in Q1 as we have historically. Given that, we were quite satisfied with a 3% comparable store sales increase on top of the 3% increase we achieved last year.

Sure. Can you help us with one last question about the model? Should we consider any kind of calendar shift cadence? In 2013, you mentioned there was about a 1 percentage point benefit to sales in the first half and then a 1 point drag in the second half. Is it a similar situation this year that we should incorporate into our models?

Yes, I would say it's similar. So to be clear, we reported on a restated basis. And you can see this in the difference between our total sales and our comp sales. So for the year, I think it's accurate that the first half has a larger negative impact than the second half. So for us, the difference between restating that week and not is worth about 200 basis points in the first quarter.

It's Jamie Merriman. My question is just about your marketing strategy. As you work on attracting younger consumers into the business, is that pivoting at all? And if so, how?

So Jamie, I would say that our marketing approach in terms of the types of media we are using has been evolving over time. It will likely continue to change as we move towards less traditional forms of media. Some of this is still experimental, and we will see how these media perform. However, I expect that over time, you will see more of this shift from us, as well as from other advertisers.

Have you found that you might be able to be more targeted and therefore lower the cost on an acquisition basis? Or is it too early to see benefits like that?

It depends on the market and the specific type of media being discussed, as well as the target audience in question. The response can vary, sometimes being yes and other times no, depending on the circumstances. This highlights that some of these channels are quite experimental, which is why we are gradually transitioning into them rather than making major changes right now.

Okay. Thank you for joining us today and for your interest in Ross Stores. Have a great day.